Cost-Volume-Profit Relationships

Chapter 1
Learning Objective 1

Explain how changes in

activity affect
contribution margin and
net operating income.
 Basics of Cost-Volume-Profit Analysis
The contribution income statement is helpful to managers
in judging the impact on profits of changes in selling price,
cost, or volume. The emphasis is on cost behavior.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Sales (500 bicycles) $ 250,000
Less: Variable expenses 150,000
Contribution margin 100,000
Less: Fixed expenses 80,000
Net operating income $ 20,000

Contribution Margin (CM) is the amount remaining from

sales revenue after variable expenses have been deducted.
The Contribution Approach
Sales, variable expenses, and contribution margin
can also be expressed on a per unit basis. If Racing
sells an additional bicycle, $200 additional CM will
be generated to cover fixed expenses and profit.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (500 bicycles) $ 250,000 $ 500
Less: Variable expenses 150,000 300
Contribution margin 100,000 $ 200
Less: Fixed expenses 80,000
Net operating income $ 20,000
The Contribution Approach
If RBC sells 400 units in a month, it will be
operating at the break-even point.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (400 bicycles) $ 200,000 $ 500
Less: Variable expenses 120,000 300
Contribution margin 80,000 $ 200
Less: Fixed expenses 80,000
Net operating income $ -
The Contribution Approach
If RBC sells one more bike (401 bikes), net
operating income will increase by $200.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (401 bicycles) $ 200,500 $ 500
Less: Variable expenses 120,300 300
Contribution margin 80,200 $ 200
Less: Fixed expenses 80,000
Net operating income $ 200
CVP Relationships in Equation Form

This equation can be used to show the profit RBC

earns if it sells 401. Notice, the answer of $200 mirrors
our earlier solution.
Profit = (Sales – Variable expenses) – Fixed expenses

401 $80,000
$80,000
401 units
units ×× $500
$500
401
401 units
units ×× $300
$300

Profit
$200 = ($200,500 – $120,300)
Variable expenses)
– $80,000
Fixed expenses
– Fixed
 CVP Relationships in Equation Form

When a company has only one product we can further

refine this equation as shown on this slide.

Profit = (Sales – Variable expenses) – Fixed expenses

Quantity sold (Q) Quantity sold (Q)

× Selling price per unit (P) × Variable expenses per unit (V)
= Sales (Q × P) = Variable expenses (Q × V)

Profit = (P × Q – V × Q) – Fixed expenses

 CVP Relationships in Equation Form
It is often useful to express the simple profit equation in
terms of the unit contribution margin (Unit CM) as follows:
Unit CM = Selling price per unit – Variable expenses per unit
Unit CM = P – V
Profit = (P × Q – V × Q) – Fixed expenses
Profit = (P – V) × Q – Fixed expenses
Profit = Unit CM × Q – Fixed expenses*

*Memorize this formula!

Learning Objective 2

Prepare and interpret a

cost-volume-profit (CVP)
graph and a profit graph.
 CVP Relationships in Graphic Form
The relationships among revenue, cost, profit, and volume
can be expressed graphically by preparing a CVP graph.
Racing Bicycle developed contribution margin income
statements at 0, 200, 400, and 600 units sold. We will
use this information to prepare the CVP graph.
Units Sold
0 200 400 600
Sales $ - $ 100,000 $ 200,000 $ 300,000
Total variable expenses - 60,000 120,000 180,000
Contribution margin - 40,000 80,000 120,000
Fixed expenses 80,000 80,000 80,000 80,000
Net operating income (loss) $ (80,000) $ (40,000) $ - $ 40,000
Preparing the CVP Graph
Break-even point
(400 units or $200,000 in sales) Profit
Profit Area
Area
Dollars

Loss
Loss Area
Area Units
Learning Objective 3

Use the contribution

margin ration (CM ratio)
to compute changes in
contribution margin and
net operating income
resulting from changes
in sales volume.
Contribution Margin Ratio (CM Ratio)
The CM ratio is calculated by dividing the total
contribution margin by total sales.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit CM Ratio
Sales (500 bicycles) $ 250,000 $ 500 100%
Less: Variable expenses 150,000 300 60%
Contribution margin 100,000 $ 200 40%
Less: Fixed expenses 80,000
Net operating income $ 20,000

$100,000 ÷ $250,000 = 40%

Each $1 increase in sales results in a total contribution
margin increase of 40¢.
Contribution Margin Ratio (CM Ratio)
The contribution margin ratio at Racing Bicycle is:

CM per unit $200

CM Ratio = = = 40%
SP per unit $500

The CM ratio can also be calculated by

dividing the contribution margin per unit by
the selling price per unit.
Contribution Margin Ratio (CM Ratio)
The relationship between profit and the CM ratio
can be expressed using the following equation:

Profit = (CM ratio × Sales) – Fixed expenses

Memorize this
Formula!
Learning Objective 4

Determine the break-

even point.
Solving for Sales Quantity (Q)

• Equation Method

Profit = (Unit CM x Q) – Fixed expenses

• Formula Method

Q = (Profit + Fixed expenses) / Unit CM

Solving for Sales Dollars (S)

• Equation Method

Profit = (CM ratio x S) – Fixed expenses

• Formula Method

S = (Profit + Fixed expenses) / CM ratio

Break-even Analysis
The equation and formula methods can be used to
determine the unit sales and dollar sales needed to
achieve a target profit of zero. Let’s use the RBC
information to complete the break-even analysis.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit CM Ratio
Sales (500 bicycles) $ 250,000 $ 500 100%
Less: Variable expenses 150,000 300 60%
Contribution margin 100,000 $ 200 40%
Less: Fixed expenses 80,000
Net operating income $ 20,000
Learning Objective 5

Compute the margin of

safety and explain its
significance.
 The Margin of Safety in Dollars
The margin of safety in dollars is the excess
of budgeted (or actual) sales over the
break-even volume of sales.
Margin of safety in dollars = Total sales - Break-even sales

Let’s look at Racing Bicycle Company and

determine the margin of safety.
Key Assumptions of CVP Analysis
1. Selling price is constant.
2. Costs are linear and can be accurately
divided into variable (constant per unit) and
fixed (constant in total) elements.
3. In multiproduct companies, the sales mix is
constant.
4. In manufacturing companies, inventories do
not change (units produced = units sold).
 5-24

End of Chapter 1